Wednesday, January 16, 2013

I visited a Herbalife nutrition club in Queens. There is plenty wrong with this company – but this is not a post about the things that are wrong with the company (most of those I will leave for other people to think about). This is simply a post about what I observed and the implications for Bill Ackman's Herbalife thesis.

(a). There are a lot of Herbalife nutrition clubs in Queens. This is an Hispanic area and within the US Herbalife is mainly an Hispanic phenomenon. If you use Google satellite navigation on your phone you will find lots Herbalife clubs (dozens are listed around Corona Queens) though some of the ones you try to locate will not be there any more (suggesting they have either moved or closed).

(b). I was told the best time to visit a nutrition club was between 7 AM and 9 AM so I dutifully arrived at about 7.15. The club was empty. I was told to go with a Spanish speaker because the clubs were pretty close to mono-lingual Spanish. The club was not signposted from the street and coloured paper made opaque the windows so a passer by would not know what was in there.

(c). I was served “all three” meaning an aloe drink, a diet suppressing tea and the protein shake.

(d). This was the first time I had drunk a protein shake. I can tell you they suck - so does the tea for that matter. This stuff tastes unbelievably bad. It is flat-out-gross. I sent an email (with the trusty smart-phone) to a friend in Asia explaining where I was and told him how gross it was. He puzzled: he asked if I was a virgin. He explained that when he was a competitive lightweight rower (he rowed for an Ivy League university) he used to live on protein shakes as he had to keep his weight within the limits. And he exercised extensively on them. Exercise and protein shakes is a well-worn and proven weight loss combination. But they do taste gross. [I have been informed that Herbalife taste slightly better than some protein shakes at the cost of adding some sugars – also I have been informed the texture is much improved by blending in a banana or even a mango....]

(e). There were no visitors prior to 8 AM. By 8 AM I was going to sell my entire Herbalife long and give up on the position. My Spanish translator talked to the guy running the place and he told us roughly how many visitors he got a day and told us the time they came in – and that it really started by about 8 AM.

(f). The translator was correct. The visitors started around 8 and in the next 75 minutes over twenty came in. They came in roughly to his schedule suggesting that they were regulars. They spoke in Spanish and he spoke to them as friends. Most of them were either no longer obese or in the transition from being morbidly obese to (merely) rectangular shaped.

(j). The key product: the proprietor/distributor greeted the visitors as friends and offered moral support as they drank the tea and the shake.

(k). There was a series of before and after photos on the wall. They were impressive – many of the customers – and the husband and wife team that ran the club – had gone from balloon shaped to roughly rectangular. [I gather before and after photos are impressive at other weight-loss groups such as Weight Watchers - however in this case there were a lot of impressive photos for a very small club.]

(l). The husband and wife who ran the shop had been Herbalife customers for about five and a half years and had been running the club for about eighteen months. They were true believers in the product – extolling its virtues and also repeating mostly in Spanish but also in Spanglish the benefits of the Herbalife system. [In their case they also also extolled the virtue of replacing the fat-and-cheeze laden meals that were non Herbalife with something more nutritious and the virtue of some exercise even if it was just walking further.]

(k). The benefits of the Herbalife program in the wife's case were real. The wife had gone from a three insulin shot per day diabetic to a half insulin shot per day diabetic. [Statistically this should add over 15 years to her life expectancy.] Her prior body was balloon shaped.

(l). On the wall was a list of the seventy odd people who regularly attend this Herbalife club. There was a list of gold stars against the names with weight-loss and Herbalife consumption targets on them. Clearly the gold stars were part of the reward system. This looked a little like primary school.

(m). We asked if he had any “downline”. He explained to us that every one of his core customers was also a distributor – and they were a distributor to get the 25 percent discount on stuff they took home.

Observations

This club was not a club selling diet drinks (but it clearly did that). It was a club selling the social support group necessary to drink diet drinks. These diet drinks work (especially when combined with a modicum of exercise). What happens though is that normal people do not have the will-power to maintain a diet drink and exercise regime. My friend in Singapore did – but then he rowed competitively and people into rowing are austere driven people (think all those 4 AM starts).

But I am a fairly disciplined person and - without social support I could not drink these shakes.

In the richer-parts of our society we have a solution to diet-and-exercise will-power problem. We hire a personal trainer (usually someone cheerful, younger and good looking) and they cajole us into weight-loss. This is a “for-hire” personal support group.

But Herbalife is another valid mechanism of getting personal support – and it clearly worked on the customers I saw. Personally I find it very difficult not to endorse a product that reduced to one sixth a person's insulin injection requirement. If Bill Ackman thinks America would be better off without Herbalife he could politely explain that at the woman's funeral.

I will - in the interest of fairness - include the main negative observation: the man who ran this shop covered his rent (we worked that out) but he was cheerful man working hard (80 plus hours a week) and making an amount that was less than minimum wage. I gather than many (possibly a majority) of Herbalife clubs do not cover rent (consistent with the observation that there are lot of Herbalife clubs in Google maps that no longer seem to exist). Minimum wage appears to be the upside.

This showed both the benefit and problems with multi-level marketing. The benefit is that it allows a company (in this case Herbalife) to get deep into a community and that is a necessary part of the product – the product they are selling is community support for weight loss and they can't do that without getting into the community. The problem is that the company actively recruits distributors to the point that it is impossible for the distributors to be good businesses. Indeed as the rewards to many people in the chain are on recruitment (and you can't make it up the chain without a substantial “down-line”) it is likely that recruitment will continue until the distributors make nothing (or less than nothing when convinced to sign up by hard-sell rather than rational argument).

There were so many Herbalife clubs around Queens that I suspect on average the Herbalife shops make something near nothing or less than nothing. The profile of a Ferrari driving Herbalife distributor that Mr Ackman presented was – at least compared to what I saw – ludicrous.

Herbalife is clearly an exploitative system in the Marxist sense. The head-honcho is paid well over $70 million derived from a vast network of people earning minimum wage or less. Dan Loeb (who now controls 8 percent of Herbalife) is someone who often attacks excessive salaries for senior executives. This could become quite amusing.

Some comments on Bill Ackman's thesis

It was striking how totally Bill Ackman's thesis fell apart from observing for just a few hours in a nutrition club.

The best way of analysing Herbalife that I can find is as alcoholics anonymous for fat (and very often Hispanic) people. I joke: “my name is Jose and I am fat”.

Herbalife works in the same way as alcoholics anonymous – by supplying (and in this case selling) a support group to help you kick the “fat addiction”.

Like Alcoholics Anonymous it has millions of members and looks – at least externally – a bit like a cult.

Herbalife like Alcoholics Anonymous has millions of members because it works. It does not work because one nutrition powder is better than another (indeed some nutritionists argue soy based powders are inferior). Herbalife works because of the support group.

AA is probably the single most effective way devised by humanity to cure alcoholics. It is far more effective than any drug developed by pharmaceutical companies and if a drug were devised as effective as and as free of side effects as AA then it would be worth tens of billions of dollars. Even then AA probably fails a majority of times. Herbalife is among the more successful ways of curing morbid obesity (but even then it probably fails a majority of times). [I shudder to think what a weight-loss drug as effective as the Herbalife support system would be worth though - considerably more than Herbalife's market cap.]

The biggest difference that I can see between AA and Herbalife is that Herbalife is (emphatically) a for-profit institution (and possibly quite an exploitative for profit institution) whereas AA is just a club.

Lets run through Ackman's presentation by section

Ackman on Herbalife as a commodity

From Page 21 to 26 of the presentation Bill Ackman “demonstrates” that Herbalife's products are not unique – and from that he argues that they do not maintain their price position by being a “proprietary product”. He compares the product to GNC and other brands and notes the price per serve or the price per calorie is higher.

This is a complete misunderstanding of Herbalife's product. GNC and other brands are sold as commodities. Herbalife is sold with a community support mechanism.

In Central Park anyone can go and have a run. It is free. It costs you $20 an hour if you exercise with a personal trainer. Comparing the price of Herbalife (sold through a network) to the GNC (sold without a network) is like comparing the cost of a run through the park without and with a personal trainer.

Bill Ackman has just missed the point.

Ackman on Herbalife's lack of advertising

From pages 27 to 31 Bill Ackman notes the lack of advertising expense on Herbalife (which he argues is very little) and says that they cannot maintain their price premium that way.

This is of course garbage. Herbalife has the best advertising possible – word of mouth. People will pay huge sums to Facebook for the hope of getting someone to “like” a product online and hence endorse it to their friends. Herbalife has far more powerful advertising support than that – it is deep in the community.

Alcoholics Anonymous has 2 million members and I have never seen an advertisement for the product. However like you I have heard of AA. Brand recognition for community based products is (naturally) very high. I suspect almost every reader of my blog has heard of Alcoholics Anonymous without ever seeing an advertisement.

That said Herbalife does sponsor one of the biggest football teams in the world (Barcelona). It also sponors LA Galaxy but nobody cares about them!

Bill Ackman on Herbalife's research and development

From page 35 to 50 Bill Ackman tells us all about Herbalife's (very thin) research and development program.

He is of course right that relative to its claims Herbalife has a very thin research and development program. So what: Alcoholics Anonymous – relevant to its claims – has a very thin research and development program. And yet it is known to work for a lot of people and the results are well known.

There is plenty of research that says social cues are important in whether you take drugs or not, whether you drink. And social cues are important as to whether you stay fat or not.

Page 164 of the Bill Ackman presentation lays out the key criteria for determining whether Herbalife is illegal. Here is the slide:

I will quote this as it is the core criteria for determining whether Bill Ackman is right:

The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

Bill Ackman spends most of his presentation arguing that Herbalife's product is the business opportunity. He argues for instance that most the product is sold to "distributors". This was clearly true in the Herbalife club I visited. Almost every customer was also a distributor. They however were clearly customers - they came in - they paid their money - they drank their shake. They look like customers because they were customers.

Bill Ackman calls these distributors victims of a false "business opportunity". Facts on the ground: they are customers.

That fact is very inconvenient for Bill Ackman because if they are customers then Herbalife is legal and Ackman's thesis falls apart totally.

Bill Ackman's logic as to why these distributors could not be customers is disarmingly simple - and amazingly erroneous. Bill Ackman argued that it was illogical for someone to sign up as Herbalife distributor for the 25 percent discount because even with a 25 percent discount the product was more expensive than commodity product available from GNC and other suppliers. [My Spanish translator came back to me with an errata on this point: he says that some of his downstream were considering the business opportunity - but the majority were distributors without any plans at all on the business opportunity.]

That is true. But it misses the point.

Remember those gold stars and the support group. If you buy weight loss shakes from GNC you do not get the gold stars. Buy the product from GNC and you are not part of this Latino self-help group. By not understanding Herbalife as a social support group for weight loss and by analysing the product as a commodity Bill Ackman has failed to observe what globally would add up to millions of customers. Real customers. The customers that make Herbalife legal.

What this story is really about

Herbalife is a company which combines a lot of good (think the life-saved diabetic above) with some pretty ugly features.

But this is not really a story about Herbalife - Herbalife will survive globally. Like all multi-level marketing schemes it will have its ups and downs. There will be all sorts of problems (such as tax compliance throughout the scheme, cash handling, perhaps even using Herbalife accounts to launder money).

What this has (deservedly) become is the story about how Bill Ackman can be so wrong. He spent (by his own admission) a year and a half analysing this company and his thesis can be falsified by visiting a few clubs in his home city. Bill Ackman's thesis is the most easily falsified bear-thesis I have seen from a major hedge fund ever.

You have to wonder how this happened. So I am going to tell you:

Bill Ackman a Harvard educated (magna cum laude) billionaire New York hedge fund manager bet over a billion dollars on a short position (imperilling his fund and his reputation) without checking the facts.

And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes.

Tuesday, January 8, 2013

There is however one quote in the article which exposes the flaw in Bill Ackman's position:

“We can’t imagine how the SEC or the Federal Trade Commission or any other relevant regulator will ignore what we have said.”

Either Bill Ackman lacks imagination or has a touching faith in government or both.

In the comments people might put a list of things you might think that Government could never possibly ignore but do. I will start with climate change. There are plenty of others: the range of government failures covers the whole political and policy spectrum.

I agreed with Bill Ackman that Herbalife is mostly about ripping off distributors and people at the end of the chain. The product is more than twice as expensive as competitor shakes. I called Herbalife "scumbags".

But they are highly cash flow positive scumbags and they will use the cash flow to buy back shares. Over the past five years the share count has gone from 140 million to 108 million and will fall further.

They are scumbags then - but they are scumbags working for stock market investors.

That I pointed out was similar to tobacco companies. Tobacco companies kill 5 million people globally per year - 400 thousand of them in the USA. Is anyone stupid enough to think the government would close them? That has been a bad short thesis for decades!

Bill Ackman is shorting a profitable company - and his argument is that they run an illegal pyramid scheme. By implication his argument that the government is going to somehow close them down.

That is a really truly awful short thesis - the short thesis that Government is going to come and help poor people and a billionaire hedge fund manager! Normally neither group is high on the agenda!

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I said that I had reported many frauds to the SEC. Sometimes the SEC acted. Mostly it did not. When it acted it was often after the stock had gone to zero.

If my thesis was the government was going to help me then I got it wrong!

Bill Ackman has that one wrong!

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I did not state other important parts of the argument.

(a). Being wrong on crowded shorts is very dangerous indeed. Herbalife is a crowded short - the short is however mostly one person - Bill Ackman - who has a massive position.

(b). The nutrition clubs have some merit. I once shared house with a lesbian Avon lady. She sold a couple of hundred thousand dollars worth of make-up a year. Her shtick was simple. She visited women stuck in outer-suburbia - the land of the 3 hours of daily commute. Their husbands were away from them for 11 hours a day and they were very stuck. She would play with them - putting makeup on them like 14 year old girls put makeup on each other. She would tell them they were beautiful and be supportive. This was multi-level marketing as decentralized support mechanism and it worked.

The nutrition clubs are like that. Fat men turn up and share a shake with other fat men and support each other to lose weight. It is sort of a Hispanic obese person's version of alcoholics anonymous. Mostly Hispanic anyway - as it started in the Hispanic community. Guys turn up and they say something like "My name is Jose and I am fat". It works.

The Manhattan version of support for weight loss is a highly priced gymnasium with a personal trainer to push you to remove the pounds. But it is blindingly arrogant to believe that that is the only valid sort of support group for weight loss.

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I also did not say what I think Herbalife's strategy should be. They are going to offer a defence. I think it should be bland - simply a statement of profits and maybe the merit of the system.

Anything to allow Herbalife to buy back more stock. Herbalife has a lot of capacity to buy back stock as it is very cash flow positive. The more stock they buy back the better for remaining shareholders.

I might wind up a remaining shareholder. So I hope they buy a huge quantity of stock back - and the easiest way to do that is to do that when the stock is cheap - that is right now.

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As per usual on this blog I could be wrong. The government might just decide to help a billionaire hedge fund manager out and save Bill Ackman from his oversized position.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.